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GameStop Isn't Playing Around

It helps that old is new again for the video-game retailer.

Even though GameStop (NYSE:GME) sells the latest in video games and systems, its bottom line is anything but child's play. It benefits from having a wide selection of titles and a leading industry magazine. And it's a pretty safe bet that kids will be buying video games for a long time, while parents like me love getting bargains on used games.

A look insideGameStop has grown its top and bottom lines, helped out by the new generation of game systems. For the first quarter, sales increased 23%, to $1.28 billion, and earnings per diluted share more than doubled, to $0.15 a share. Gross margins did decline by 170 basis points, to 27.3%, but management explained that the drop was caused by the new game systems, which made up a larger share of sales and have lower margins. This problem should therefore abate going forward, as GameStop sells more games.

Cash flow for the quarter came in at negative $288.8 million. This is a typical showing for the first quarter, though, when items such as accounts payable decrease as the company pays off purchases from the previous holiday selling season. GameStop also built up its inventory of new video-game system hardware and related software.

Last year, the company generated $423.5 million in cash flow from operations, and it used some of that amount to repay debt. As a result, in the past year, the long-term debt on its balance sheet has gone from nearly $1 billion to about $737 million, and I expect to see further debt reduction. Consider that despite the negative cash flow in the current quarter, the company still repaid more than $100 million of its debt.

GameStop's recent results have been benefiting from the next-generation systems -- the Sony (NYSE:SNE) PlayStation 3 and the Nintendo (OTC BB: NTDOY.PK) Wii. Developers have come out with new titles for both systems, but this cycle has a new twist: The older systems are still important in terms of revenue, since not everybody upgraded right away, and some gamers decided that the old hardware was still pretty good. In addition, the new systems have backward compatibility, so the old games will play on the new systems. Our house is one of the oldies, in fact. We still have PlayStation 2 for the kids ... and me.

Speaking of older merchandise, used games and products accounted for 25% of GameStop's top line last year, but generated almost 50% of the company's gross profit. For its latest quarter, used games made up a similar 25.5% of sales but were hugely profitable. It generated gross margins of more than 50% and accounted for more than 51% of gross profits. And that's despite offering the merchandise at a discount to other outlets, such as Blockbuster (NYSE:BBI). The difference-maker is that kids run to GameStop for its incentives. For example, people getting new systems might be able to trade in three PlayStation 2 games and get one PlayStation 3 game for free.

GameStop publishes also its own magazine, Game Informer, which is immensely popular and profitable. It's the largest multiplatform video-game magazine in the United States, based on circulation. Lumped with other software and accessories, as well as character-related merchandise, this group generated 16.5% of GameStop's top line in the latest quarter, but it accounted for one-third of the gross profit and carried a gross margin of 33.8%.

What makes it workAfter joining forces with Electronics Boutique in 2005, GameStop is now the largest retailer of video games and entertainment software in the world. Its retail stores, operating under the GameStop and EB Games banners, offer new and used video games, as well as hardware and accessories for next-generation video game systems from Sony, Nintendo, and Microsoft (NASDAQ:MSFT). PC entertainment software, related accessories, and other merchandise are also available at the stores.

The company has advantages over other retailers such as Blockbuster and Best Buy (NYSE:BBY), in that it offers a wider selection of games from all three major systems. I also know my 10-year-old son loves going into EB Games or GameStop to try out the different systems available. As a parent, I like having him try out the games to see what they're all about before I make a purchase.

ValuationLast week may have presented a buying opportunity. GameStop's shares declined by as much as 7% one day, after Take-Two Interactive Software (NASDAQ:TTWO) announced that it would delay the launch of its new version of Grand Theft Auto IV game. But GameStop's broad product base should help protect it from overreliance on one title.

Now that the shares have recovered some of their value, the stock is not cheap. It trades at a trailing price-to-earnings ratio of 38. Even taking its performance and popularity into consideration, the stock looks pricey, so I'd advise investors to wait for dips before grabbing a controller in this particular game.

Fool contributor Larry Rothman is happy to receive feedback, and he promises to read it when he's not being wrestled by his three children. Feel free to email him at rothmanviews@comcast.net. He doesn't have any positions in the companies mentioned. The Fool's disclosure policy does not require a strategy guide.